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Heading Upstream: A Route
to Commodities that Bypasses
the Futures Market
Elizabeth Collins, CFA, Associate Director of Equity Research, Basic Materials
Upstream and downstream producer equities offer the benefits of commodity investing while
avoiding derivatives and futures curves, as seen in the Morningstar Commodity
Producers Index family and the Morningstar Global Upstream Natural Resources Index.
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Investors’ love affairs with commodities continues unabated.
Whether they’re looking for diversification, an inflation hedge, or
to speculate on rising prices, investors have plowed hundreds
of billions of dollars into commodity-related offerings, including
both mutual funds and exchange-traded funds. Investments
in commodity mutual funds, for example, have grown to more
than $137.6 billion by the end of 2011 from $9.2 billion at
the end of 2002. The growth story for commodity-tracking ETFs
is even more impressive—assets have skyrocketed to $150.4
billion from $770 million over the same period. Suffice it to say
that we’ve come a long way since legendary investor and
commodity aficionado Jim Rogers lamented, “Commodities get
no respect.” 1 This statement would be far from the truth today.
Many Ways to Invest in Commodities
There are three avenues to gain exposure to commodities:
1. Physically hold the commodity. Physically backed exposure
offers perfect tracking (net a management fee) to the
underlying commodity, since the investor actually owns the
physical commodity. However, this is really only feasible for
high value-to-weight ratio commodities such as gold.
Figure 1. Total Assets in Commodity Mutual Funds and Exchange-Traded Funds (US)
Commodity-related investment offerings have experienced rapid growth over the last decade.
350
300
Commodity Equities ETFs
250
200
Commodity Equities Mutual Funds
Commodity Futures & Physicals ETFs
Commodity Futures & Physicals Mutual Funds
150
USD Billions
1. Rogers, Jim.
Hot Commodities: How
Anyone Can Invest
Profitably in the World’s Best
Market. 2004.
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2002
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2. Buy commodity futures. In this strategy, the investor holds
futures contracts that obligate the purchase or sale of a
set quantity of a commodity, at a set date in the future, and at a
set price. Historically, there have been three return drivers of
futures-based investments: spot return, collateral yield, and roll
yield. There are numerous vehicles available to invest in
a futures-based strategy that attempt to optimize these three
return drivers. But the futures market can be multifarious,
requiring investors to have an understanding of how roll yield
works (gains or losses incurred when a contract expires
and is rolled into the next one).
3. Purchase equity of the producer. As a final option, one
can choose to invest in equity-based products that provide
underlying commodities exposure.
Equity-Based Exposure to Commodities
Investing in equity-based products to gain commodities
exposure has broad appeal, as it offers:
3 Convenience: Equity vehicles, such as stocks, are convenient,
easy to access, and are less complex than playing the
futures market.
3 Wider selections: Using commodity equities also widens the
opportunity set to gain exposure to the asset class. Not all
commodities have futures associated with them, such as iron
ore, timber, water, and coal.
3 Outperformance: It’s also feasible that commodity equities
will outperform commodities themselves in a rising
price environment. For any given percentage increase in price,
a producer’s profits will increase by a greater percentage,
all else equal. This leverage to commodity prices is greater
for higher-cost producers (those with lower profit margins).
Furthermore, higher prices usually mean that more of
a company’s potential resources are economical to produce.
The investment growth perfor­mance of AK Steel and Nucor
during the runup in steel prices (which occurred between
the recovery from the Asian financial crisis and the peak before
the global financial crisis) illustrates the greater leverage to
commodity prices for higher-cost produc­ers. A $10,000 investment in AK Steel in 2004 returned more than $190,000 by 2009
as compared to $70,000 for Nucor. AK Steel is one of the
highest-cost steel producers in the United States. The company
must purchase costly iron ore, and it has significant legacy and
financial costs. In contrast, Nucor is one of the country’s
most efficient steel producers. The firm has low-cost electric
arc furnaces and doesn’t need to purchase iron ore. It has no
legacy liabilities and lower financial costs. While AK Steel’s
disadvantaged cost position is a serious threat during
weak industry conditions, its shareholders benefit from its
high degree of leverage during boom times.
Commodity Producers—An Analyst’s View
There are several considerations that are unique to this
investment strategy, including:
3 Cost profiles: As the price of its product changes, a commodity
producer’s position on its industry cost curve can have a
tremendous effect on its financial performance, and hence the
performance of its shares. Smaller, marginal producers with
extremely unfavorable cost profiles will tend to see very volatile
movements in their share prices from movements in the
prices of their relevant commodities. This is because relatively
small movements in the prices of the commodities (and in
the company revenues) can have an outsized effect on these
firms’ earnings.
3 Financial leverage: Highly indebted commodity producers
(much like high-cost marginal producers) will tend to see
more volatility in their share price performance in response
to changing fundamentals.
3 Operational diversification: There are very few pure-play
commodity producers in existence. Most producers will
have diverse exposure to a number of different commodities
or end markets. Take BHP Billiton, for example. The firm
produces a wide variety of commodities ranging from coal to
diamonds. An investment in a mega-miner such as BHP
provides a degree of diversification across commodities and
geographies, but still leaves one exposed to firm-specific
risk—such as the potential for ill-timed, overpriced acquisitions,
which were numerous during the most recent runup in
commodity prices. Other company-specific risk factors, such
as business and management risk, don’t exist when investing
directly in commodities and also warrant consideration.
3 Hedging policies: Some commodity producers may take future
price risk off the table by locking in selling prices today. If they
do so, they may be either capping future upside in their
earnings power, or mitigating potential downside should their
product prices subsequently fall below these hedged prices.
Heading Upstream: A Route to Commodities That Bypasses the Futures Market
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Not All Commodity Companies Are Created Equally
Morningstar Index Solutions
Not all companies or investment options are equal when it
comes to gaining exposure to commodities. In most cases,
upstream producers—those directly involved in extracting or
harvesting the resources from Mother Nature—are the ones
that offer the highest leverage to commodities. Downstream
companies—those that buy raw commodities and then process
or refine them for end markets—tend to afford less leverage
to commodities. The most important measure for determining
whether a company is an upstream or downstream producer
is to look at the correlation to the underlying commodity spot
price itself. Upstream producers have higher correlations.
In an effort to provide investors with the greatest opportunity to
leverage underlying commodities through an equity-based
solution, Morningstar offers two differentiated ways to achieve
investment exposure to commodity producer equities.
Exxon Mobil is a company that many investors might turn to for
exposure to energy prices. Indeed, Exxon Mobil generates
approximately 80% of its profits from upstream activities, or the
actual production of oil and natural gas. These activities
benefit from higher oil and gas prices. However, Exxon Mobil’s
downstream activities in crude oil refining and chemical
manufacturing can suffer from high energy prices, since these
commodities are raw materials. In fact, the rise in energy prices
has led to lower refined product demand in developed markets.
In this way, higher energy prices hurt refining activities on
both the cost and demand fronts. Pure exploration and production companies such as Occidental Petroleum, on the other hand,
are more leveraged to energy prices than integrated firms such
as Exxon Mobil. While the integrated business model affords
less leverage to energy prices, this also means less volatility in
earnings and equity valuation. We illustrate this in Figure 2.
Morningstar® Global Upstream Natural Resources IndexSM
The Morningstar Global Upstream Natural Resources Index was
launched in 2011. This index measures the performance
of stocks issued by companies that have significant business
operations in the ownership, management, or production
of natural resources in energy, agriculture, precious/industrial
metals, timber, and water resources sectors. The index
methodology uses a proprietary industry classification system to
identify companies within these five natural resource categories.
Individual stock weights, as well as category and regional
exposure, are capped to promote diversified exposure. Figure 3
demonstrates the stock assignment process for the Morningstar
Global Upstream Natural Resources Index.
Morningstar® Commodity Producers Index Family
An alternative approach is the Commodity Producers Index
family, which is designed to offer a high correlation with
underlying commodities while supplying upstream commodity
exposure to companies that do not hedge against production,
(excluding gold mining). The Commodity Producers Index family
consists of distinct indexes covering agriculture, energy,
metals and mining, and gold.
Figure 2. Growth of a $10,000 Investment—Occidental Petroleum vs. Crude Oil vs. Exxon Mobil
Pure exploration and production companies are more leveraged to energy prices than integrated firms.
100,000
90,000
80,000
Occidental
Petroleum
70,000
60,000
50,000
Crude Oil
(Spot Price)
Exxon Mobil
40,000
30,000
USD
20,000
10,000
0
2003
2004
2005
2006
2007
2008
Morningstar Indexes 2012 13
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Figure 3. Morningstar® Global Upstream Natural Resources Index Stock Assignment
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Industry
(Secondary
Priority)
Agriculture
Energy
Agricultural
Inputs
Oil & Gas
Exploration and
Production
Farm Products
Chemicals
Specialty
Chemicals
Diversified
Industrials
Integrated
Oil & Gas
Metals
& Mining
Aluminum
Industrial Metals
& Minerals
Gold
Water
Timber
Utilities—
Diversified
Lumber & Wood
Production
Utilities—
Regulated Water
REITs
Paper &
Paper Products
Coal &
Consumable
Fuels
30
30
15
15
Weight (%) 30
30
30
5
5
Conclusion
Investors interested in commodities face many investment
options. Commodity equities provide investors with exposure
to changes in spot commodity prices and expectations
for future commodity prices. If investors choose equity-based
commodity investing, Morningstar offers several solutions
with the Morningstar® Global Upstream Natural Resources
Index, and the Morningstar® Commodity Producers Index
family. These unique index offerings, developed in conjunction
with equity analysts, present indexes that are easy to invest
in and based on transparent, noncomplex methodologies. K
Oil & Gas
Refining
& Marketing
30
Stock Limit
Rather than embrace a standard market capitalization weighting
system for these indexes, Morningstar’s weighting system
assigns scores to each company based on its structural leverage
to commodity prices and its market capitalization. The weighting
schemes used in these indexes include sensitivity factors,
as shown in Figure 4, placing higher weights on upstream
companies within each index based on their structural leverage
to commodities—agricultural inputs or oil and gas
exploration, for example.
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Figure 4. Morningstar® Commodity Producer Index Family Construction Process
Morningstar
Commodity Producer Indexes
Global Equities
Investable Universe
Developed
and Emerging
Market
Countries
Liquidity
Screen
Morningstar
Global Equities Indexes
Investable securities from
U.S., Developed Ex-U.S.,
and Emerging Market
Countries
Commodity
Producers
Screen
Industry/
Sensitivity
Factor
(4 = High,
1 = Low)
Agriculture
Energy
Agricultural
Inputs 4
Oil & Gas
Exploration and
Production 3
Farm &
Construction
Equipment 3
Farm Products 2
Confectioners 1
Integrated
Oil & Gas 2
Coal &
Consumable
Fuels 1
Metals
& Mining
Aluminum 1
Diversified
Metals & Mining
1
Gold
Gold Mining
Companies
(Producers Only)
Steel 1
Precious Metals
& Minerals 1
Oil & Gas
Refining &
Marketing 1
Weighting:
Float Market Cap
Sensitivity Factor
Float Market Cap
Sensitivity Factor
Float Market Cap
Sensitivity Factor
Float Market Cap
Sensitivity Factor
(based on
hedging policies)